Serbia and MontenegroLetter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of UnderstandingNovember 29, 2004

The following item is a Letter of Intent of the government
of Serbia and Motenegro, which describes the policies that Serbia
and Motenegro intends to implement in the context of its request
for financial support from the IMF. The document, which is the property
of Serbia and Motenegro, is being made available on the IMF website
by agreement with the member as a service to users of the IMF
website.

Firm implementation of our medium-term economic program supported by
the Fund under the Extended Arrangement (EA) has permitted good progress
in stabilization and reform. To ensure continued progress and address
new challenges, we have updated our economic and policy targets for 2004-05,
as described in detail in the attached Memorandum on Economic
and Financial Policies. On this basis, we request: (a) completion
of the fourth semi-annual review (including the eighth financing assurances
review) under the EA; (b) waivers for the non-observance of an end-June,
2004 performance criterion (the passage of the Serbian bankruptcy law)
and two end-September, 2004 performance criteria (contracting or guaranteeing
new nonconcessional external debt from multilateral creditors by the public
sector in Montenegro; and non-assumption by the public sector of enterprise
debt to banks in Montenegro); (c) the purchase of SDR 62.5 million following
the completion of the fourth review; and (d) a rephasing of purchases
for the remainder of the program by combining the tenth and eleventh purchase,
to become available upon completion of the fifth review which would be
postponed to cover the end-December 2004 test date. The non-observed quantitative
performance criteria for which waivers are requested were missed by small
margins and the Serbian bankruptcy law was adopted with a short delay.
We are taking measures to improve policy implementation in these areas.

We believe that the policies and measures described in the attached memorandum
are sufficient to achieve our program objectives, but we stand ready to
take timely additional measures and seek new understandings with Fund
staff, as necessary, to keep the program on track. We will remain in close
consultation with the Fund staff on the adoption of these measures, and
in advance of any revisions to the policies contained in the attached
MEFP in accordance with the Fund's policies on such consultations. We
will provide all information to the Fund that it requests to assess the
implementation of the program. The program will continue to be reviewed
by the Fund, with the discussions for the next review, together with the
Article IV consultation, expected in January 2005. The next review will
focus on progress in structural reforms (including budgetary employment
reduction, enterprise restructuring and privatization, bank reform), and
on the implementation of fiscal, monetary, incomes and exchange rate policies.
Moreover, each purchase under the arrangement will continue to be subject
to a review of the financing of the program.

1. This memorandum updates and supplements the Memorandum of Economic
and Financial Policies (MEFP) attached to the Letter of Intent of May
21, 2004. It reports on recent developments under the program supported
by the Extended Arrangement (EA) approved in May 2002 and updates the
economic objectives and policy agenda for the remainder of 2004 and for
2005.1

2. The performance under the program  supported by the Extended
Arrangement with the Fund  is broadly on track. While four end-June
performance criteria (PCs) were not met, all but two end-September PCs
were observed. The end-June ceilings for the NDA of the central bank and
bank credit to government in Serbia were missed, but observed at end-September.
In addition, the end-June PC on contracting or guaranteeing new nonconcessional
external debt from multilateral creditors was breached by Montenegro;
this PC, and that on debt guarantees was also breached at end-September.
The Montenegrin government is committed to avoiding similar breaches in
the future. The end-June structural PC for Serbia on electricity tariffs
was met on time, while that on the bankruptcy law was met with a slight
delay owing to scheduling difficulties in Parliament. The end-June and
end-September indicative targets on the wage bill of state enterprises
were exceeded. A number of additional indicative targetson net credit
to government, arrears, banking system NDA, and central government dinar
depositswere not met at end-June, with the latter two missed also
at end-September, calling for improved policy implementation. End-June
structural benchmarks on the VAT law and bank privatization, and recovery
of banks assets were met (the latter with some delay). The end-September
structural benchmarks in Serbia and Montenegro on asset recovery have
not been met. Both governments are seeking to address these delays.

3. Strong growth in 2004 has been overshadowed by accelerating inflation
and an increasing external imbalance.

Twelve-month inflation in Serbia rose to 11½ percent in
September, driven by cost and demand factors, while inflation in Montenegro
fell to 2.1 percent by August.

Real growth is likely to reach 6 percent led by a bumper crop
in agriculture and solid industrial growth supported by output gains
in recently privatized enterprises. Demand was boosted by an increase
in consumption fed by an estimated 12 ½ percent increase in real
wages through August in Serbia and rapid credit growth in both republics
(especially in consumer lending and leasing).

Rapid growth of foreign currency deposits, along with an increase
in foreign loans to banks in Serbia, have continued to fuel lending
to the nongovernment sector, which rose by 30 percent in real terms
in the 12 months ending in Augustalbeit from a low base. In Montenegro,
credit growth in the year to August exceeded 40 percent.

The SM current account deficit deteriorated further in the first
six months of 2004 compared to a programmed improvement, and is projected
to reach 13 percent of GDP by year-end. Imports rose by 32 percent
year-on-year especially of cars by more than 50 percent, while export
growth lags behind. Higher-than-projected world oil prices account for
about 0.7 percent of the projected higher external deficit. Private
remittances continue to be high, projected at 14 percent of GDP in 2004,
but FDI is expected to fall to 4 percent of GDP, reflecting a slowdown
in privatization in the first half of the year. Net foreign reserves
rose to US$3.5 billion (3.6 months of projected 2005 imports) at end-September
2004.

The debt dynamics will benefit from the recent completion of negotiations
with London Club creditors, but the increase in the debt financing of
the current account deficit raises concern. The London Club
agreement implies a reduction of the debt to commercial banks of 62
percent, reducing the country's overall debt burden by 7 percentage
points of GDP. However, an increasing share of the external deficit
is financed by debt (about 37 percent) making the country more vulnerable
to external shocks. The increase in foreign borrowing is keeping the
debt/GDP ratio at a projected 58 percent at end-2004.

Confidence in the dinar has remained fragile, and the share of
foreign currency deposits in total deposits has increased. The dinar
has depreciated by 2 percent in real effective terms in the year through
September.

4. Fiscal policy in Serbia was tightened after June to safeguard annual
inflation and external balance targets, while tax reform advanced.
Total revenue was broadly in line with the program at end-September, and
expenditure has been under tight control since July, which corrected for
higher than expected spending in the first six months. The shift towards
indirect taxes advanced with the elimination of the wage bill tax (July
2004), rationalization of the social contribution rates and bases (July
and September 2004), increases in excises on gasoline, diesel, and cigarettes
(July 2004), a new lottery tax (July 2004), reduced corporate income tax
to 10 percent (September 2004), and cancellation of the financial transaction
tax (effective January 2005). The January 1, 2005 introduction of the
VAT will further advance this shift. In Montenegro, total revenue fell
below programmed levels despite strong VAT revenue performance, but prudent
budget execution has kept the deficit in line with the program.

5. Monetary policy was also tightened at mid-year to rein in inflation
and the widening external deficit. The NBS raised the interest rate
on its bills during June-July, and increased the required reserve ratio
by 3 percentage points from August. These measures tightened liquidity
by about 0.6 percent of GDP.

6. The implementation of structural reforms has resumed since July.
Serbian Parliament approved a package of 17 economic reform laws in mid-July.
Privatization has recommenced with the issuance of tenders for 8 socially-owned
enterprises. Financial sector reform is continuingJubanka has been
offered in a public tender as programmed and its sale to a strategic investor
is expected to be completed around the end of the year. Tenders for sale
of Continental Banka and Novosadska Banka were published in late September.
The conversion of all Paris and London Club as well as FFCD-related liabilities
into state-owned equity in banks to be privatized is also essentially
complete.

II. Economic Objectives and Policies

7. The economic objectives for 2004-05 and beyond reflect robust growth
in incomes while addressing higher inflation and safeguarding a sustainable
external position (Table):

End-period inflation will accelerate to 12-13 percent in 2004
due in part to one-off exogenous shocks, but is targeted to fall under
10 percent in 2005, and to gradually decline to low single digits over
the medium term (inflation in Montenegro is projected to decline to
2½-3 percent in 2004, outperforming original forecasts, and is
expected to remain in this range in 2005).

The external current account deficit (before grants) is projected
to recede to 12 percent in 2005 as policies aimed at containing domestic
demand take effect. Higher oil prices are estimated to account for about
a percentage point of this deficit. To ensure external sustainability
and remain consistent with expected financing, the deficit is projected
to decline steadily thereafter based on a recovery of exports as structural
reforms elicit a supply response and prudent policies strengthen competitiveness.
As structural reforms accelerate and the business climate improves over
the medium term, FDI inflows could play an increasing role in financing
the current account deficit, allowing a gradual decline in reliance
on foreign assistance and loans.

The import coverage of foreign reserves at end-2004 will remain
unchanged from end-2003, with a view to guarding against possible risks
and preparing for the projected rise in external debt service in the
medium-term following the expiry of grace periods under debt restructuring
agreements.

8. Economic policies will be geared to support sustainable growth
while narrowing the external current account deficit. Fiscal policy
and monetary policy will support current account adjustment while the
health of the financial sector will be improved and structural reforms
accelerated to increase export potential with the support of appropriate
safety-nets.

Table 1. Macroeconomic framework

2003

2004

2005

Actual

3d Review

Proj.

3d Review

Proj.

(Percentage change)

Real GDP Growth

3.0

4 - 5

6.0

4 - 5

4 - 5

Inflation (end period)

7.8

8 - 9

12.5

5.0

9 - 10

Of which : Montenegro

6.7

4.0

2.8

3.5

2.6

(Percentage of GDP)

Domestic investment

16.1

16.8

16.5

17.5

17.8

Domestic savings

-6.4

-4.0

-8.7

-2.6

-7.3

Current account deficit (before grants)

12.0

11.0

13.0

10.0

12.0

Gross official reserves (US $ billion)

3.6

3.6

3.7

4.2

4.2

In months of projected imports

3.7

4.3

3.7

4.7

3.9

Total external debt

69.9

55.1

58.4

54.1

57.4

Net external debt

48.2

36.2

39.1

32.7

36.1

Underlying net external debt1

48.2

...

46.8

...

50.2

Fiscal deficit

3.4

2.3

2.0

0.9

0.8

Sources: SM authorities; and IMF staff
estimates.1Underlying net debt excludes the impact of write-offs
in London Club, other commercial, and official bilateral debt.

9. The PRSP process will continue to guide the development agenda
and social policies. The PRSPs adopted by the Serbian and by the Montenegrin
governments in late 2003 outline the key reforms. Social spending will
be protected to provide a safety net for those affected adversely by reforms,
while its efficiency will be enhanced through the improved targeting of
benefits.

A. Fiscal Policy

10. Fiscal policy in 2004 and 2005 will continue to anchor the stabilization
effort and improve medium-term sustainability. Fiscal policy will
be tightened by 1.4 percent of GDP in 2004 and 1.2 percent (1.7 percent
excluding redundancy payments) in 2005, largely through cuts in expenditures.
Reflecting the tightened fiscal stance, prudently assumed privatization
proceeds (1.6 percent of GDP), and foreign disbursements (1.1 percent
of GDP), the fiscal program for 2005 envisages a build-up of government
deposits equivalent to 0.6 percent of GDP. As in previous years, privatization
proceeds beyond program targets will be used to reduce net government
indebtednessand if consistent with achieving program objectives
and in consultation with the Fund in the context of program reviewsto
cover investment and restructuring costs.

Serbia

11. Fiscal policy for the remainder of 2004 will be tighter than programmed
to reduce external vulnerabilities. To scale back government spending
as agreed in the third review, the Parliament passed a budget amendment
bill in October (prior action for the Fourth Review). The supplementary
budget includes an additional cut of 0.2 percent of SM GDP in view of
heightened pressure on the current account deficit in addition to budgetary
reallocations in line with the understandings under the Third Review (MEFP
paragraph 16). The supplementary budget (i) substantially increases allocations
for the social funds to ensure timely payment of entitlements; (ii) allocates
resources for payment to London Club creditors (2.5 billion dinars); and
(iii) cuts spending relative to the appropriations in the 2004 Budget
Law, notably subsidies to agriculture and transportation, net lending,
bank restructuring, and goods and services. With these measures, the consolidated
fiscal deficit of the Serbian general government is projected to decline
from 3.0 percent of GDP in 2003 to 1.7 percent of GDP in 2004 (from 2.5
percent to 1.2 percent excluding FLFPs).2

12. Fiscal policy in 2005 will be further strengthened to support
the stabilization effort. The overall deficit of the Serbian general
government in the 2005 budget (whose submission to Parliament is a prior
action for the Fourth Review) will be cut by 1.1 percentage points to
0.6 percent of GDP (a surplus of 0.1 percent excluding FLFPs).3
Since total revenue as a percentage of GDP is expected to fall in 2005
with the legislated reduction of the tax burden, expenditure cuts will
bear the brunt of the adjustment while laying a foundation for further
fiscal consolidation in the medium term. With a tighter deficit and projected
privatization proceeds of 1.6 percent of GDP and net external disbursement
of 0.9 percent of GDP, the budget sector is expected to reduce it demands
on net domestic financing by 2.0 percent of GDP in 2005.

13. The tax burden will continue to shift from labor to consumption
to increase savings, growth and job creation. A broadly revenue neutral
two-rate VAT (standard rate 18 percent, reduced rate 8 percent) will replace
the retail sales tax in January 2005. Fees and taxes on securities transactions
will be eliminated by January 1, 2005. The various changes in taxes are
projected to lower tax revenue to 35.9 percent of GDP in 2005, partially
compensated by strengthened collection of nontax revenue boosted by higher
dividends from state-owned enterprises. Total revenue would decline by
0.8 percentage points to about 39.5 percent of GDP.

14. Expenditures will be reduced and rationalized. Virtually all
non-interest current expenditure items will need to be rolled back as
a share of GDP. At the same time, the budget will need to make room for
larger interest obligations, and higher severance payments to support
structural reform. Expenditure as a share of GDP is projected to decline
to 40 percent.

Longer term fiscal sustainability will call for cuts in the public
sector wage bill. By end-July 2005, government employment will be
streamlined by 7 percent in the general government. The Law governing
labor relations in public institutions will be amended by end-March
2005 to allow a 12-month severance package for the retrenched workers
of the republican budget, to be paid out in two equal installments of
CSD 5 billion (0.3 percent of GDP) each, in July 2005 and January 2006
(see paragraph 27 of the TMU). The law will also be amended to increase
labor market mobility in the public sector and facilitate the dismissal
of redundant workers. The employment cut will create some room within
the total wage bill of CSD 79 billion excluding redundancy pay, to pay
higher salaries to selected highly-trained government workers to retain
their service and motivate performance. In addition, budgetary support
for active labor market policies will increase in 2005 to facilitate
re-employment of retrenched workers.

To achieve further decompression of the public sector wage ratio
between skilled and unskilled workers and to keep the growth in the
wage bill on a sustainable path, the government will agree on key elements
of civil service reform by end-November. Building on the enactment
of the Civil Service Law by end-March 2005 (structural benchmark) and
with World Bank assistance, it will formulate a comprehensive plan by
end-June 2005 to overhaul the civil service, as part of its overall
strategy for public sector administration reform. This plan will cover
the reform of the systematization procedure and provide an overall review
of the staffing levels across the state administration.

To accelerate restructuring, subsidies will be cut by 0.5 percent
of GDP in 2005, including in the railway company (ZTP), broadcasting
(RTS), agriculture, and mining. However, subsidies for enterprise
restructuring will be better targeted, and budget resources for the
Transition Fund to cover restructuring in socially-owned and state-owned
enterprises will sharply increase in 2005, with 1.2 billion dinars (0.1
percent of GDP earmarked for the lattersee paragraph 27 of the
MEFP). To enforce compliance, subsidies will not be given to any entity
that is not a registered taxpayer. Effective immediately, no payments
from the Transition and Serbian Development Funds will be made to any
enterprise that (i) has new arrears to the general government budget
excluding penalties on pre-existing arrears starting from September
2004; (ii) raised its wage bill in the past 12 months by more than projected
inflation; and (iii) failed to abide by its restructuring program.

Pending further reform of the social funds, transfers to the Employee
Pension Fund, Farmer Pension Fund, and the Labor Market Fund will continue
to enable them to make full benefit payments in 2005. Despite recent
reform, the EPF remains in need of large financial support from the
budget on an annual basis. Concurrently, the government will, with World
Bank assistance, draw up a plan by end-March 2005 to address the structural
problems of the EPF to ensure its medium-term viability. To address
the financial plight of the Farmer Pension Fund, a comprehensive plan
to deal with the FPF will be made by the same time. Given the tight
budgetary situation, recently announced plans for the clearance of one-half
month of EPF arrears in 2005 will be made conditional on the overall
budgetary revenue performance and, if needed, will be delayed by one
year. In any case, this payment will not be made before Q4 2005.

To increase efficiency in Union institutions, nominal transfers
to the Union budget will remain broadly at their 2004 level. The
ensuing adjustment of 0.4 percent of GDP will be supported by streamlining
Union employment by about 15 percentincluding through early retirement,
voluntary redundancies, and natural attritionin early 2005, and
by other measures. To this end, (i) 2.0 billion dinars will be earmarked
for redundancy payments (see paragraph 27 of the MEFP), and (ii) the
Serbian and Montenegrin governments will amend the Law on the Yugoslav
Army and the Law on Union-level Civil Employees to harmonize them with
Republic-level legislation. The amendments will reduce the amount of
redundancy payments from 24 to 12 months and the period of dismissal
from 3 months to 30 days (submission to Federal parliament is a prior
action and its enactment an end-December performance criterion). The
Serbian and Montenegrin governments will work jointly on a strategy
to reduce employment in the defense sector through early retirements
and cuts in civilian employment. The Serbian and Montenegrin Ministries
of Finance will monitor all off-budget military revenues and expenditures
of the recently created Military Fund (MF) financed from the sales of
military assets and rental income, which will be treated as budgetary
spending under the program with the view of their eventual incorporation
in the budget. For this purpose, all accounts of the MF will be brought
into the Treasury Single Accounts by end-2004.

Transfers to local budgets (including for teachers in Vojvodina)
will double to compensate for their loss of sales tax revenues after
the introduction of the centralized VAT in 2005 (2 percent of GDP).
The share of personal income tax revenue for local budgets will be increased
from 30 percent of total collection in 2004 to 40 percent in 2005.

Expenditure on goods and services and other programs will be curtailed
as a percent of GDP, while budget-financed capital spending (excluding
military spending) will remain broadly constant as a share of GDP.

While the budget law includes an annual ceiling on contracting
and guaranteeing public debt, a mechanism will be included in the
public debt law to effectively monitor and control the granting of government
guarantees and the disbursement of FLFPs to ensure that the desired
fiscal policy stance is implemented.

15. The policies will be supported by reforms in tax administration.
To ensure a smooth introduction of the VAT in January 2005, remaining
outstanding enabling decrees for the VAT implementation were issued in
October 2004. In addition, the government will request a follow-up VAT
technical assistance mission to visit Belgrade in March 2005 to assess
the initial VAT implementation and recommend early corrective measures,
if needed. In line with international best practice, the selection criterion
for large taxpayers will be changed to turnover by end-2004, rather than
the current practice based on total revenues collected from 3 tax sources.
Taxpayer services will be strengthened. By end-March-2005, taxpayer services
for (a) tax law interpretation, (b) filling tax returns, and (c) tax liability
information will be extended to all major tax offices country-wide in
Belgrade, Novi Sad, Ni, and Kragujevac. Finally, to further enhance
restructuring and improve financial discipline, the government will develop
a plan to reduce enterprise arrears to the budget and social funds by
end-November (structural benchmark).

16. Public expenditure management will benefit from Treasury reorganization
and increase control over indirect budget users. As part of its reorganization,
the Treasury will issue an action plan by March 2005 that will fully integrate
the Public Payment Agency into the Treasury. With the Road Directorate
brought into Treasury Single Account in August, all direct budget users
are now fully covered by the TSA. Over the medium term, all accounts of
indirect budget users will also be brought into the TSA. As a first step,
the Treasury will draw up by June 2005 a full inventory of all indirect
budget accounts denominated in dinars and foreign currency. To further
strengthen public expenditure management, the government will by end-June
2005 submit a law requiring local governments to publish audited budget
accounts.

17. Reform of the payroll system is a high priority. The MOF will
implement a work program to pull together the present disaggregated payroll
data bases and to move to a more centralized payroll processing that will
allow fuller control over wage expenditures. To achieve these objectives,
the MOF will undertake by end-March an audit of basic personnel records
in budget institutions. In addition, it will review the Systematization
Act for any vacant position that is not filled for more than a year and
recommend their elimination. The MOF will strengthen its payroll division
to allow it to initially construct and maintain a simple but reliable
centralized database for all direct budget users. During 2005 this division
will develop a program, jointly with the Budget Inspection Service, to
carry out routine payroll management checks against the data base of key
indirect budget users. By January 2006, the division will develop and
introduce a standardized software package and complementary information
system.

Montenegro

18. Fiscal adjustment continues in Montenegro. The 2004 general
government deficit (before grants and foreign loan-financed projects,
FLFPs) is targeted at €36.1 million, or 2.4 percent of Montenegrin
GDP. In 2005, the fiscal deficit (before grants and FLFPs) will fall to
€25.8 million, or 1.6 percent of Montenegrin GDP. Government approval
and public announcement of the additional 2004 cuts and submission to
the Parliament of the draft budget for 2005 in line with this MEFP will
be prior actions for Board consideration of the fourth review. Over the
medium term, the government is committed to continue lowering the deficit
to ensure fiscal and external sustainability.

19. The government will maintain a predictable tax environment and
protect the revenue base. Tax reforms will be implemented only in
the context of annual budget laws or amended budgets, making revenue-reducing
tax policy changes conditional on the availability of adequate revenues
or offsetting measures to safeguard the deficit target. Such tax policy
changes will not be considered if (i) actual recurrent budget revenues
are below the budgeted levels, and/or (ii) the budget has accumulated
new expenditure arrears during the year. The government will not extend
the VAT rebate program based on retail receipts beyond November 2004.
The second step of lowering PIT and social contribution rates that was
originally envisaged on December 1, 2004 will only be followed by further
reductions in PIT rates during 2005 and beyond if actual revenue performance
exceeds projected levels by a sufficient margin to allow such cuts. The
decision on further PIT rate reductions will be taken in close consultation
with IMF and World Bank staff. There will not be further reductions in
social contribution rates during 2005. The planned reduction in the Corporate
Income Tax rate from 20 to 9 percent will only be effective from 2006.
Finally, the government will refrain from extending new exemptions or
differential VAT rates to any sector, and avoid restructuring tax debt
in a manner that would undermine its tax collection over the medium term.

20. Fiscal adjustment will also be supported by prudent expenditure
policies. To reduce the high share of non-discretionary expenditures,
the government will cut budget-financed employment from its end-2003 level
of 26,000 by 1,000 by end-2004, and by a further 800 in each quarter of
2005. Discretionary spending will be further reduced in 2005, with the
amount of net lending and subsidies falling to 0.9 percent of Montenegrin
GDP. The government will also avoid new privatization-related spending
obligations (i.e., no subsidies or price guarantees will be provided to
privatized companies, and no debt to third parties assumed unless already
guaranteed by the government). The government will refrain from spending
in the first half of 2005 the €7 million reserve it has set aside
in the 2005 budget for the contingency that the December 2004 reductions
in social contribution rates result in additional needs for transfers
to the Pension and Health Funds. Finally, the government will cap the
total amount of subsidy paid to Nikic Steelworks under its privatization
contract at €0.8 million in the draft 2005 budget and phase this
subsidy out completely by end-2008.

21. The government will continue implementing a cautious strategy
of domestic borrowing. Government net domestic financing (excluding
FFCD repayment) will not exceed €12 million in 2004, and €10½
million in 2005. The government will continue developing the treasury
bill market extending the maturity profile of its debt. The government
will also continue increasing the share of treasury bills in total domestic
financing, and will eliminate reliance on non-transparent loan agreements
with individual banks and companies by end-2005.

D. Monetary and Exchange Rate Policies

22. The monetary program for the remainder of 2004 will continue tight
credit policy to help contain domestic demand and inflationary pressures.
For the year, end-period NFA are programmed to be broadly unchanged, while
monthly average NDA will decline slightly from August, implying a 3.5
percent growth in reserve money during the last quarter. Dinar broad money
and credit to the economy are projected to rise by 13.8 and 38½
percent during 2004, respectively. The NBS will stand ready to sterilize
foreign exchange inflows to contain credit expansion.

23. The efficiency of money market operations will be strengthened.
To increase its capacity to manage market liquidity, the NBS will expedite
the implementation of repo operations. The government will submit to Parliament
a draft law on the settlement of government liabilities to the NBS by
end-November 2004, with a view to facilitating by end-2004 the restructuring
of government debt held by the NBS into marketable bonds eligible for
repo operations. In addition, to enhance public liquidity management and
avoid implicit subsidies to banks, the remaining republican government
and NBS deposits will be withdrawn from commercial banks by end-2004,
except from one bank undergoing privatization. Meanwhile, by end-October
2004, the Ministry of Finance and the NBS will establish joint procedures
for strengthening the coordination of fiscal and monetary policies, forecasting
market liquidity and demand for T-bills and NBS-bills, determining the
schedule for issuing these bills, and projecting government deposit flows.

24. Macroeconomic risks related to rapid credit expansion will be
assessed. The NBS will prepare by end-March 2005 a detailed loan survey
and a regular reporting standard, providing data on loans-and leasing
contracts extended by Serbian bank-owned leasing companies-by industry,
currency denomination, term-structure, and type of borrowers (including
a breakdown of loans to households into consumer and mortgage lending),
to monitor these risks. To increase transparency in the banking sector,
the NBS will publish quarterly reports on banking industry trends starting
with the report for end-2004.

25. The NBS will implement prudential measures to contain macroeconomic
risks resulting from rapid credit growth. The rapid credit expansion,
particularly the strong increase in credit to households, has contributed
to an unsustainable rise in the current account deficit. Against this
background, the following measures will be implemented:

The NBS will issue by end-December regulations requiring banks to
assess and manage credit risk resulting from borrowers' exposure to
exchange-rate risk, inter alia by determining borrowers' ability to
service loans denominated in or indexed to foreign currency in the event
of exchange rate changes.

The NBS and the government will support the recently established
credit bureau in charge of monitoring individual's credit risk exposure
and payment history in accordance with the EU Directives. By end-March
2005, the credit bureau's data base will be extended to comprise data
on leasing activities, tax arrears and arrears to utilities, and lending
to enterprises.

The NBS will issue by end-November 2004 a guideline to banks on consumer
credits (excluding mortgage loans) that will recommend (i) limiting
the monthly payment-to-net income ratio to 30 percent; and (ii) requiring
a down payment of at least 20 percent of the purchase price of acquired
goods. The NBS will also indicate to banks that stronger measures, including
an increase in reserve requirements, will be considered if credit growth
fails to slow down significantly. The NBS will inform Fund staff in
writing by December 8, 2004 on the details of the banks' response as
regards complying with the guideline.

To remove a bias in favor of foreign-sourced funding, by January
1, 2005 the NBS will broaden the reservable base by including (i) the
stock of commercial banks' foreign borrowing of maturities of up to
4 years; and (ii) all new foreign borrowing by commercial banks independent
of maturities.

To reduce prudential risks, the NBS will increase the capital adequacy
ratio from 8 percent to 10 percent in March 2005.

The NBS will explore the modalities for starting to regulate and
supervise leasing companies, and work with the government on drafting
legislative changes to be discussed with Bank and Fund staff during
the upcoming FSAP mission. Meanwhile, the NBS will assess the appropriateness
of the current limit for connected lending between banks and leasing
companies, while the Serbian government will assess by end-November
2004 the tax treatment of leasing contracts.

26. Exchange rate policy will continue to balance the objectives of
reducing inflation and the external imbalance. Against the background
of a large and growing current account deficit, exchange rate policy will
be flexible and contribute to improving competitiveness, while at the
same time strengthening confidence in the dinar. Exchange rate policy
will be assessed frequently in light of current account, wage, and inflation
developments.

E. Bank Reform and Financial Supervision

27. The NBS will substantially strengthen financial sector supervision.
To this end, it will group all banks and insurance companies according
to their respective risk assessment, with their supervisory plans clearly
laid out by end November 2004, and cross-check banks' submitted reports
against external audit reports by end-2004. An on-site assessment of the
bank posing the largest potential systemic risk will be launched by end-2004,
and the bank will adopt a time-bound plan by end-2004 to strengthen internal
controls and governance. To send a clear signal that regulatory forbearance
is ceasing, the NBS will further strengthen on-site and off-site supervision,
and strictly enforce existing regulations. In particular, the NBS will
withdraw the license of banks that do not meet the €10 million minimum
capital requirement by end-2004, unless they are recapitalized by reputable
investors with banking experience or meet the requirement through a merger
(structural benchmark). The license of further banksif anyfailing
to meet the minimum capital requirement will be withdrawn by end-March
2005. To improve financial sector transparency and market discipline,
all banks, insurance and leasing companies will publish IAS compliant
end-2004 financial results by end-June 2005. The NBS will also strictly
enforce prudential requirements for insurance companies and require comprehensive
year-end audits, with management letters provided to the NBS.

28. In Serbia, progress in bank privatization and resolution will
continue and governance in BRA-controlled banks will be strengthened.
Building on progress in privatizing Jubanka, the BRA will launch the privatization
tender for Nika Banka by end-2004 (structural benchmark). Meanwhile,
management in the two largest banks with state-majority holdings has been
improved. For Vojvodanska Banka, the tender for a privatization advisor
was issued on October 7, 2004 with a view to appointing the advisor by
end-February 2005, and launching the tender for its privatization in the
third quarter of 2005. Concurrently, with bilateral assistance, the BRA
will further strengthen its reporting requirements, control mechanisms,
and governance in other nationalized banks to preserve their value prior
to resolution. After some delays due to legal procedure, the BRA will
launch the sale of its residential mortgage loan book by end-2004 and
initiate the sale the 25 largest corporate and commercial unimpaired (non-public,
not on privatization list, not bankrupt) loans by end-March 2005. Meanwhile,
Parliament will adopt new laws on Deposit Insurance, Bank Liquidation,
and Bank Rehabilitation Agency by end-March 2005, after consultation with
World Bank and IMF staff.

29. In Montenegro, banking supervision will remain vigilant and bank
privatization and asset resolution will continue. The CBM has further
strengthened banking supervision, in particular by further improving compliance
with Basel core principles and strengthening the focus on risk management.
Moreover, it has remained vigilant in light of rapid credit expansion,
inter alia by ensuring that a moderate deterioration in the quality of
banks' loan portfolio was appropriately accompanied by an increase in
loan-loss provisioning. To further reduce state influence in the banking
sector, the government will launch a tender for a privatization advisor
for the largest state-owned bank by end-November and sign the contract
with the advisor by end-2004. The privatization tender will be launched
by end-April, 2005. The government and the CBM will also prepare a strategy
by end-2004 to divest all state minority holdings from the banking system,
and refrain from increasing this stake in the banking system in the meantime.
The government will begin by end-2004 the sale of non-financial assets
carved out from the banking sector, initiating by end-March 2005 the sale
of at least 50 percent of the unimpaired assets, and by end-June 2005
all remaining unimpaired assets. To level the playing field for banks
and improve Treasury cash management, all republican government deposits
with commercial banks will be transferred to the single treasury account
in the CBM by end-2004 (structural benchmark), with the exception that
republican government deposits at Podgoricka Banka will decline by €2
million from their end-August level, and fall to zero by end-June 2005.
Finally, enhanced balance sheets for the central bank and for deposit
money banks will be available by end-2004 to improve the monitoring of
banking and fiscal developments.

F. Enterprise Sector

30. Wage bills in state enterprises will continue to be controlled
to contain inflation pressures and encourage restructuring. To help
ensure that the state enterprise wage bill remains under control, the
government will pass by end-November a decree requiring ex ante approval
by the Ministries of Labor and Finance for wage increases in 8 public
utilities. On this basis, the government agrees to treat the wage bill
ceiling on the 7 monitored public utilities as a performance criterion
from end-December 2004.4 The wage bill in
the monitored state enterprises in 2005 will be allowed to grow by 7 percent
on an average basis. To facilitate the necessary cost rationalization,
detailed business plans, including new organization charts (sistematizacija)
will be prepared by end-2004 for most monitored public utilitiesincluding
for NIS, EPS, and ZTPclearly showing redundant workers. Redundancy
payments for the laid-off workers will be covered from the non-wage budgets
of the enterprises and from the Transition Fund in the budget (0.1 percent
of GDP). In the event of spin-offs as a result of future restructuring,
the monitored wage-bill envelope will be adjusted downward for the wage-bills
of the spun-off units.

31. Accelerating the privatization and restructuring of socially-owned
enterprises is critical for improving export performance and for rapid
sustained growth. To this end, we will ensure that:

The Privatization Agency (PA) will offer for sale, through auctions,
135 companies between October 1 and December 31, 2004 and will sell
at least 50 percent of these companies; and another 60 companies between
January 1 and March 31, 2005, out of which at least 40 percent will
be sold.

The PA will offer for sale 3 companies from the list of companies
under restructuring through tenders or auctions, or parts thereof through
asset sales between October 1 and December 31, 2004; and three more
companies from the list between January 1 and March 31, 2005. The launch
of tenders for 3 companies will be a prior action for the review.

The PA will complete the first Share Fund sale through a public offer
compatible with the Securities Law by December 31, 2004, and submit
to Parliament amendments to laws necessary to enable steady progress
in Share Fund sales by end-March, 2005. On this basis, it will revive
sales of residual state-owned shares in socially-owned enterprises either
through public offers or through sales via the Stock Exchange. At least
three more such transactions will be initiated by end-March 2005.

The government will also ensure progress in the remaining large privatization
transactions, which will allow the launch of a tender for a privatization
advisor for at least one of the following telecom privatization transactions
by end-March 2005: (i) mobile telephone operations of Srbija Telekom;
(ii) Mobtel; (iii) third mobile license (excluding Srbija Telekom, PTT,
and Mobtel from participating as buyers). The government will ensure
that all tenders are carried out transparently, in accordance with international
best practice.

To ensure fiscal transparency, all privatization proceeds will be
treated as budgetary financing (below the line) and spending will follow
normal budgetary procedures.

32. To accelerate privatization, we envisage debt workouts for large
socially-owned enterprises coordinated by a unit under the Deputy Prime
Minister's supervision. The framework for such agreements will be
strengthened through amendments to the Privatization Law by [end-2004],
which will enshrine the principle of write off of enterprise debts to
state creditors and public utilities, conditional upon privatization.
To enable the privatization of highly indebted enterprises by reducing
their debt without creating moral hazard, write-offs of tax and social
contribution arrears, and of obligations to public utilities or state-owned
banks will be conditional on actual sale or final bankruptcy, and most
often involve a haircut for remaining creditors imposed by an inter-ministerial
negotiating group. Private creditors may accept haircuts in return for
prompt payment, or may be forced to do so by public sector creditors wheneveras
is most often the casepublic sector creditors account for the majority
of claims.

33. An effective bankruptcy process provides a critical building block
of the government's strategy for strengthening enterprises' financial
discipline. The bankruptcy process will become fully operational by
end-February 2005, following the adoption of bylaws to the Bankruptcy
Law and the establishment of: (a) a Supervisory Body to license, supervise,
and regulate bankruptcy trustees; (b) a specialized unit within the Privatization
Agency to act as bankruptcy trustee for state- and socially-owned enterprises.
As part of this process, an amendment to the Law on the Privatization
Agency enabling the PA to act as the bankruptcy trustee agency for state-
and socially-owned enterprises will be enacted by end-2004 (structural
performance criterion). The government will complement rapid progress
toward a functioning bankruptcy process by initiating bankruptcy procedures
under the new regulations against three large, heavily indebted, and loss-making
socially-owned conglomerates under restructuring programs by end-March
2005.

34. The Serbian government is firmly committed to improving the financial
performance of the railway company (ZTP) by accelerating restructuring
and downsizing employment. Delays in restructuring and excessive employment
have created large losses and imposed a substantial budgetary burden through
annual subsidies of ¾ percent of GDP. Against this background,
the Ministry of Capital Investment will prepare by end-February 2005,
in consultation with the Ministry of Finance and World Bank and Fund staff,
a restructuring plan drawing on the Business Plan for 2004-2008 elaborated
by the consulting company Booz-Allen-Hamilton. This restructuring plan
will provide detailed timetables covering 2005 for (a) reducing labor
redundancies; (b) spinning off all non-core activities of ZTP with a view
to privatizing them; (c) potentially closing loss-making secondary railway
lines, if the respective segments are not taken over by investors in the
form of subconcession contracts; and (d) raising the price of passengers'
tickets and freight tariffs early in the year. Moreover, the government
will submit to parliament by end-March 2005 a transportation law agreed
with the World Bank that provides for the unbundling of ZTP into separate
transportation and infrastructure companies.

35. The Serbian government will continue restructuring public utilities
based on strategic plans.

The government will create an operational regulatory framework with
an independent regulatory body for natural monopolies by end-2004, and
will prepare a modern law on royalties to be paid by companies involved
in extracting natural resources, for which it will request World Bank
assistance.

It will ensure that after its unbundling by end-February 2005 (performance
criterion) into two separate companies, one for power generation, distribution
and distribution system management, and one for transmission and dispatch,
EPS will (i) complete the spin-off of all non-core activities; (ii)
reduce its core employment by 7 percent (relative to end-September 2004),
in line with the company's strategic plan; (iii) service all its debt
to the government in full except for Kosovo-related debt; and (iv) not
receive any budgetary subsidy in 2004-2005.

To enhance collection and strengthen enterprise budget constraints,
public utilities will enforce penalties on late payments and cut off
supplies to commercial users that are not honoring their payment obligations
for more than two months. If the government considers that continuation
of delivery to these enterprises is imperative for strategic or social
reasons, the utility bills will be paid from the budget.

Finally, to raise transparency in the sector, all monitored public
utilities will publish by end-June 2005 an auditor's report on their
2004 accounts in line with IAS prepared by a reputable international
auditing firm engaging a review partner with relevant industry experience
from outside the local office.

36. Privatization in Montenegro is proceeding. The Nikic
steel company has been privatized, hotels are being sold at a brisk pace,
and the large aluminum company (KAP) is at an advanced stage in its privatization
process. In addition, Montenegro Telecom is expected to be offered for
sale in the first half of 2005. The republican budget's privatization
proceeds have been conservatively budgeted at €6 million in both
2004 and 2005, but can be higher without affecting deficit targets (i.e.,
additional privatization receipts will be offset with equal reduction
of net domestic financing). The government will refrain from granting
electricity subsidies to privatized companies or extending any government
guarantees.

G. Foreign Trade System

37. The foreign trade system is being harmonized internally and liberalized
through regional agreements. Following an agreement on a timetable
to harmonize the trade, customs, and indirect tax regimes of the two republics
adopted in August 2003, tariff rates have been harmonized with the exception
of tariff lines for 56 agriculture products and of special import levies
and seasonal tariffs for a range of additional products. All export and
import quotas have been eliminated. A Joint Customs office with competence
on trade with EU countries has been set up. Even though the harmonization
processas requested by the EUis not yet complete, the
EU has signaled that it could adopt a more flexible approach towards the
preparation of a feasibility study for the Stabilization and Association
Agreement. Significant progress in the resolution of the outstanding issues
with the European Commission relating to sugar trade has allowed the resumption
of sugar exports to the EU. A trade agreement to liberalize trade in textiles
with the EU is expected to be finalized by the end of the year. Discussions
on bilateral Free Trade Agreements with neighboring countries within the
initiative of Stability Pact-aimed at facilitating trade through harmonized
rules and standards, and simplified customs procedureshave progressed
well. Free Trade agreements with Albania, Bosnia and Herzegovina, Bulgaria,
Croatia, Moldova, and Romania have been ratified and implemented, while
work is underway to review the trade agreement with Macedonia. Preparations
for the WTO accession process are continuing, with the first meeting of
the Serbia and Montenegro Task Force for WTO accession envisaged in 2005.
Customs operations are expected to be further strengthened, including
at the Union level. To avoid backtracking on reforms and maintain a competitive
market environment, both member states will refrain from introducing or
intensifying import restrictions. Serbia and Montenegro agree to improve
the comparability of respective external sector data, and provide foreign
debt data on a periodic basis.

III. Program Monitoring

38. Macroeconomic policy performance under the EA will continue to
be monitored through quarterly quantitative performance criteria and indicative
targets (Annex B). Progress in structural reform
will be monitored through structural performance criteria and benchmarks
on key policy measures (Annex D). Quarterly targets
for 2004 remain as set in the Third Review documents except for a revision
in the end-December ceiling on Montenegro's nonconcessional multilateral
borrowing and an end-December performance criterion added for the wage
bill of monitored state-owned enterprises in Serbia. Quarterly performance
criteria are also proposed for end-March, 2005. Parliamentary approval
of a revised 2004 budget for 2004 in Serbia and parliamentary submission
of annual 2005 budgets for Serbia and for Montenegro in line with policies
described in this memorandum, as well as issuing tenders for 3 socially-owned
enterprises in Serbia, government approval and public announcement of
the additional 2004 budget cuts in Montenegro, and submission to federal
parliament of amendments to two laws governing union-level employment
will constitute prior actions for Board consideration of the fourth review
under the Extended Arrangement (Annex D).

1. This memorandum replaces the Technical Memorandum of Understanding
attached to the Memorandum of Economic and Financial Policies of May 21,
2004. It sets out the understandings regarding the definitions of quantitative
and structural performance criteria, benchmarks, and indicative targets
for the program supported by the Fund under an Extended Arrangement (EA),
as well as the related reporting requirements. The key changes in this
updated memorandum include definitional changes in the external debt ceilings
and data revisions.

2. To monitor developments under the program, the authorities will provide
the data listed in each section below to the European Department of the
Fund, in accordance with the indicated timing. The quantitative performance
criteria and indicative targets will be monitored on the basis of the
methodological classification of monetary and financial data that was
in place on December 31, 2002, except as noted below. Quantitative performance
criteria and indicative targets for end-December 2004, end-March, end-June,
end-September and end-December 2005 are specified in Annex
A of the Memorandum of Economic and Financial Policies
(MEFP).

3. For program purposes, the public sector consists of the consolidated
general government (comprising union operations, Serbian state and local
governments, the Montenegrin state government, the Serbian and Montenegrin
social security funds, and the Serbian and Montenegrin special budgetary
programs), the National Bank of Serbia (NBS), and the Central Bank of
Montenegro (CBM). The authorities will inform the Fund staff of any new
funds or special extrabudgetary programs that may be created during the
program period to carry out operations of a fiscal nature as defined in
the IMF's 2001 Manual on Government Financial Statistics, and will ensure
that these will be incorporated within the definition of consolidated
general government.

For purposes of the program, foreign reserve assets shall be
defined as monetary gold, holdings of SDRs, the reserve position in
the IMF, and NBS holdings of foreign exchange in convertible currencies.
Any such assets shall only be included as foreign reserve assets if
they are under the effective control of, and readily available to, the
NBS. In particular, excluded from foreign reserve assets are: frozen
assets of the Union of Serbia and Montenegro (SM), undivided assets
of the former Socialist Federal Republic of Yugoslavia (SFRY), long-term
assets, NBS claims on resident banks and nonbanks, as well as subsidiaries
or branches of SM commercial banks located abroad, any assets in nonconvertible
currencies, encumbered reserve assets (e.g., pledged as collateral for
foreign loans or through forward contracts), and precious metals other
than monetary gold. For program purposes, all euro and foreign currency-related
assets will be evaluated at program exchange rates; for 2004,
the program exchange rates are those that prevailed on December 31,
2003. In particular, US$1 = CSD 54.6372, €1 = CSD 68.3129, and
SDR1 = US$ 1.4806. Monetary gold shall be valued at an accounting price
of US$ 416.85 per ounce. On September 30, 2004, the NBS's foreign reserve
assets as defined above amounted to US$3,622.4 million, including gold
valued at US$140.4 million.

For purposes of the program, foreign reserve liabilities shall
be defined as any foreign-currency-denominated short-term loan or deposit
(with a maturity of up to and including one year); NBS liabilities to
residents and nonresidents associated with swaps (including any portion
of the NBS gold that is collateralized) and forward contracts; IMF purchases;
and loans contracted by the NBS from international capital markets,
banks or other financial institutions located abroad, and foreign governments,
irrespective of their maturity. Undivided foreign exchange liabilities
of SFRY are excluded. On September 30, 2004, the NBS's foreign reserve
liabilities, as defined above, to nonresidents were US$1,086 million
and to residents were US$954 million.

All assets and liabilities denominated in convertible currencies
other than the U.S. dollar shall be converted at their respective exchange
rates against the U.S. dollar prevailing on December 31, 2003. All changes
in definition or in valuation of assets or liabilities, as well as details
of operations concerning sales, purchases or swap operations with respect
to gold shall be communicated to the Fund staff within one week of the
operation.

5. Reporting. Data on foreign reserve assets and foreign reserve
liabilities of the NBS shall be transmitted to the European Department
of the Fund on a weekly basis within four business days of the end of
each business week. To facilitate program monitoring, the NBS will provide
the data at the indicated constant prices and exchange rates, as well
as at current exchange rates. The NBS will report if any of the reported
foreign reserve assets are illiquid, pledged, swapped, or encumbered.

6. Adjustors. For program purposes, net foreign assets will be
adjusted upward pari passu to the extent that: (i) after September 30,
2004, the NBS has recovered frozen assets of the FRY, assets of the SFRY,
long-term assets, and foreign-exchange-denominated claims on resident
banks and nonbanks, as well as SM commercial banks abroad; and (ii) the
restructuring of the banking sector by the Agency for Deposit Insurance,
Rehabilitation, Bankruptcy, and Liquidation of Banks (BRA) involves a
write-off of NBS foreign-exchange-denominated liabilities to resident
banks. The net foreign assets floor will be adjusted downward by the shortfall
relative to the programmed level of net external budgetary financing cumulative
from December 31, 2003 (US$217.4 million through end-December 2004), and
cumulative from December 31, 2004 (US$40 million through end-March 2005,
US$40 million through end-June 2005, US$95 million through end-September
2005, and US$95 million through end-December 2005) with a maximum adjustment
of US$100 million. The net foreign assets floor will also be adjusted
by the amount that the end-September, 2004 outcome is revised.

B. Ceiling on Net Domestic Assets of the NBS

7. Definition. For purposes of the program, net domestic assets
(NDA) of the NBS are defined as the difference between reserve money (as
defined in section F) and net foreign assets (as defined in section A),
with the latter being converted from U.S. dollars into dinars at the program
exchange rates as specified above. The ceiling is established as the monthly
average of each month with an end-month test date (i.e., the averages
of December 2004, of March, June, September, and December 2005, respectively).
The monthly average of NDA for program purposes will be calculated as
the difference of the monthly average of reserve money and monthly average
of NFA. The monthly average of NFA will be adjusted so that the disbursements
of World Bank program loans and EU macro-financial assistance are counted
as if they occurred on the first day of the month in which they were effected.
As of September 30, 2004, NDA of the NBS so defined were valued at CSD
-21,924 million (Annex B).

8. Adjustors. The NBS's NDA ceiling is subject to the same adjustor
for excess or shortfall in combined budgetary external financing and privatization
proceeds for the consolidated Serbian government as defined in Section
C, except that the limit for upward adjustment is CSD 2.5 billion. The
adjustment for excesses/shortfalls in combined budgetary external financing
and privatization proceeds is asymmetric: (a) it applies to the NDA ceiling
but not to the NFA floor (except that shortfalls in budgetary external
financing trigger an equal downward adjustment in NFA up to a limit of
US$100 million); and (b) upward adjustments in NDA are capped at the equivalent
of 0.2 percent of programmed annual GDP, while no limits apply to downward
adjustments. This treatment takes into account that: (a) privatization
proceeds reflect partly sales to residents (i.e., not directly affecting
NFA), so that a downward adjustment in NDA in response to higher than
programmed privatization proceeds may not necessarily lead to a corresponding
increase in NFA or may do so with a considerable lag (money demand is
not stable in the short run); and (b) the need to safeguard foreign reserves.

9. Reporting. The ceilings will be monitored on the basis of daily
data on NBS foreign reserve assets and liabilities as defined under section
A, and reserve money (as defined under section F), supplied to the European
Department of the Fund by the NBS within four business days of the end
of each business week. To facilitate program monitoring, the NBS will
provide daily its foreign reserves liabilities, as well as the amounts
and dates of World Bank and EU macro-financial assistance disbursements
at the current and the program exchange rates.

C. Ceiling on the Net Credit of the Banking System
to the Consolidated General Government

10. Definition. The banking system comprises the NBS and commercial
banks licensed by it in Serbia, as well as the CBM and commercial banks
licensed by it in Montenegro. The consolidated general government was
defined above.

For program purposes, net credit of the banking system to the consolidated
general government is defined as all claims other than frozen foreign
currency deposit (FFCD), bonds (i.e., credits, securities, and other
claims in both dinar and foreign currencies) of the banking system on
the consolidated general government less all deposits of the consolidated
general government with the banking system, including foreign currency
deposits. Foreign currency deposits and foreign-currency-denominated
credits to the general government will be reported at the program exchange
rates. Net bank credit to the consolidated general government in Montenegro
will be monitored on the basis of data supplied by the Montenegrin authorities;
at end-September 2004, net credit of the banking system in Montenegro
to the consolidated general government in Montenegro amounted to €6.473
million (equivalent to CSD 442 million). At end-September 2004, net
credit of the banking system to the consolidated general government
so defined was CSD -18,368 million.

11. Reporting. The ceilings will be monitored using end-month
data on the accounts of the banking system supplied to the European Department
of the Fund with a lag not to exceed three weeks.

12. Adjustors. For program purposes, the ceilings on net credit
of the banking system to the consolidated general governments will be
adjusted downward by the cumulative increase in the stock of government
debt held by the nonbank public (other than that related to the frozen
foreign currency deposits), starting from January 1, 2003, and upward
for any decrease. These performance criteria will be adjusted by the amount
that the end-December 2003 outcome is revised. In addition, in the event
of a shortfall in the sum of net foreign budgetary financing and privatization
proceeds, the ceilings will be adjusted upward by 75 percent of the shortfall
subject to the total adjustment limit of CSD 5 billion for Serbia's and
€6 million for Montenegro's consolidated government. The ceilings
will be adjusted downward for the excess of combined net external budgetary
financing and privatization proceeds relative to budgeted levels that
are not used (1) to reduce the government's external indebtedness by more
than envisaged under the program, or (2) to cover investment and restructuring
costs in consultation with the Fund in the context of reviews under the
EA. Privatization receipts are defined to include all cash privatization
receipts (defined as cash received by the government including the privatization
agency), including those channeled to extrabudgetary funds, and from asset
sales by the public sector and by state-owned or socially-owned enterprises.
Net external budgetary financing is defined to include all budgetary (i.e.,
non-project) grants and loans, less amortization (on a cash basis). The
estimation of the shortfalls (excesses) in the sum of net foreign budgetary
financing and privatization receipts will be based on the following projections
(cumulative from the beginning of the year specified) with the actual
inflows evaluated at the average exchange rates of the month when funds
are received:

Serbia (2004, in billions of dinars)

Dec

External Financing

11.1

Privatization proceeds

8.3

Serbia (2005, in billions of dinars)

Mar

Jun

Sep

Dec

External Financing

2.6

2.6

6.5

6.5

Privatization proceeds

4.5

15.1

20.3

25.7

Montenegro (2004, in € million)

Dec

External Financing

39.8

Privatization proceeds

15.0

Montenegro (2005, in € million)

Mar

Jun

Sep

Dec

External Financing

7.0

8.0

9.0

10.0

Privatization receipts

1.6

3.2

4.7

6.2

D. Nonbank Domestic Financing

13. Definition. Nonbank domestic financing to the consolidated
general government is defined as any form of resident financing for the
consolidated budget deficit other than (i) from the NBS, (ii) from commercial
banks, and (iii) privatization proceeds. This will include domestic financing
from nonbank financial institutions, nonfinancial enterprises, households,
and all other domestic financing not elsewhere classified. Nonbank domestic
financing covers any net change in the consolidated general government
liabilities to any of these institutions, representing either direct loans
or advances to the consolidated general government or holdings of securities
of the consolidated general government, including promissory notes or
other contractual obligations. FFCD payments are treated below the line
as negative domestic nonbank financing.

14. Adjustor: if quarterly net nonbank domestic financing deviates
from the projected quarterly cumulative path (coinciding with projected
cumulative FFCD payments) provided below in billions of dinars, the excess
(shortfall) will trigger an equal downward (upward) adjustment in (i)
net banking system credit to the consolidated general government (performance
criterion) and in (ii) net banking system credit to the consolidated general
government in Serbia (indicative target).

2005

Mar

Jun

Sep

Dec

Projected Nonbank Domestic Funding

0.0

17.4

20.9

22.5

E. Ceiling on Change in Domestic Arrears

15. For program purposes, indicative targets will be set on the change
in domestic arrears. Separate indicative targets will be set for the consolidated
general government of Serbia (including union-level spending), and the
consolidated general government of Montenegro.

16. Definition

For the purpose of establishing compliance with this indicative target,
union-level expenditure is defined to comprise all budgetary activities
specified in the Constitutional Charter, including the SM army and the
SM pension fund for retired military personnel. The consolidated general
government of Serbia is defined to comprise all budgetary institutions
financed from the Serbian state budget, the Republican Pension and Invalidity
Insurance Fund for Employees, the Republican Pension and Invalidity
Insurance Fund for Self-employed, the Republican Pension and Invalidity
Insurance Fund for Agricultural Workers, the Republican Health Insurance
Fund, the Republican Labor Market Agency, all republican special directorates,
and all other budgetary and extrabudgetary funds created by the government
of Serbia existing before or created during the period of the program.
The consolidated general government of Montenegro is defined to comprise
all budgetary institutions financed from the state budget, the Republican
Pension and Invalidity Insurance Fund, the Republican Health Insurance
Fund, the Republican Labor Market Fund, and all other budgetary and
extrabudgetary funds created by the government of Montenegro existing
before or created during the period of the program.

The outstanding stock of domestic arrears comprises wage and pension
arrears; arrears with respect to accrued tax and social security contribution
obligations, including personal income tax and social security contributions
of employees withheld at source; arrears on social entitlement benefits
(apart from pensions) to households; arrears incurred with respect to
the purchases of goods and services from suppliers; arrears related
to the servicing of domestic debt and nonpayment of budgeted transfers
to finance union-level expenditures.

The outstanding stock of wage arrears at a particular date are defined
as total accumulated unpaid wages of all employees on the regular payroll
of all units belonging to the parts of the general government as defined
above, up to the latest preceding regular pay date, which have not been
settled by the test date. The total stocks of wage arrears, thus defined,
are on a gross basis and are calculated by summing the wage arrears
of all units of government with regard to their own employees; transfers
between different levels of government for making wage or other payments
are excluded from the estimates of these wage arrears.

Pension arrears are defined as total accumulated pensions due but
not disbursed by the pension funds concerned to all pensioners in the
pension rolls up to the latest preceding pension disbursement date.

The outstanding stocks of tax and social contribution arrears at
a particular date comprise total accumulated accrued tax obligations
of the parts of the general government as defined above that have not
been paid by the test date. The total stocks of such arrears are on
a gross basis.

Social entitlement payments, apart from pensions, are defined as
all cash payments due directly to, or on behalf of, the population in
accordance with stipulations in the law and which are not contingent
upon the provision of any services or sale of any goods or assets to
the general government by such members of the population in return for
these payments. The stock of such entitlement arrears are defined as
total accumulated payments due but not disbursed by all units of government
up to the test date. Thus defined, these arrears are also on a gross
basis and do not include the netting out of any transfers made between
different units of the general government for the payment of such entitlements.

Arrears to suppliers comprise payments delayed beyond what was explicitly
specified in relevant contracts, or in the absence of such specification,
for two months from the date of submission of bills, for already-effected
purchases of goods or services by the government concerned. These include,
inter alia, arrears to utility companies, arrears incurred with respect
to service and maintenance contracts, and payments for capital goods.
These arrears are also defined on a gross basis. Thus, overdue tax and
other obligations to the government of relevant enterprises are not
included in the calculation of the arrears of the government, and netting
out of any transfers made between different units of the general government
for the payment of such arrears and obligations are also not taken into
consideration.

Arrears to domestic banks and nonbank lenders comprise all overdue
payments related to financial contracts between the government and domestic
banks, nonbanks, and private lenders.

€ denominated claims on government will be converted at the
program exchange rate; claims denominated in currencies other than the
€ will first be converted at their respective program exchange
rates against the € . The change in arrears is defined as the change
in the end-period stock of arrears. Changes in wage and pension arrears
will be adjusted for the changes in the average wage and average pension
in the economy relative to their respective values in September 2004.

17. Reporting. Before the last business day of each month following
the end of a quarter, data on end-period stocks of arrears for the previous
quarter will be supplied to the European Department of the Fund by the
Ministry of Finance of Serbia, and the Ministry of Finance of Montenegro.

F. Definition of Reserve Money

18. Definition. Reserve money is defined as the sum of currency
in circulation (NBY Bulletin, September 2000, Table 3A, column 8) and
dinar reserves banks are required to hold at the NBS, plus excess reserves
of the commercial banks. Shortfalls in reserves that banks are required
to hold will be included in required reserves (and therefore in reserve
money), as well as in bank borrowing from the NBS. As of September 30,
2004, the required reserve ratio was at 21 percent of the base as defined
in NBS Decision of March 28, 2002. Subsequent changes in the reserve requirement
will be reflected in program definitions. The amounts that banks are permitted
to hold in securities to satisfy the statutory reserve requirement will
be limited to the amount that banks were holding as of December 31, 2000
(CSD 174.1 million). Excess reserves include commercial banks' (1) balances
in Giro accounts 620, 621, 623, and 625; (2) overnight deposit in account
205 at the NBS; (3) excess balances above required reserves on account
201 at the NBS (with the shortfall in required reserves counted as negative
excess); and (4) cash in vaults.

19. Data on reserve money will be monitored from the daily monetary indicators
of the NBS, which will be supplied to the European Department of the Fund
weekly by the NBS with a three-day lag. The end-month data is based on
the NBS balance sheet, which will be provided to the Fund with a lag of
less than three weeks. On September 30, 2004, currency in circulation
amounted to CSD 42,463 million, while required reserves amounted to CSD18,738
million, and excess reserves to CSD 2,934 million. For program and projection
purposes, monthly averages of reserve money and its components were used.
Data on effective reserve requirements and the deposit base used in reserve
requirement calculations will be supplied to the European Department on
a ten-day basis with a lag of less than a week.

20. Adjustors. For program monitoring purposes, reserve money will be
adjusted as follows. Should the standard reserve requirement increase
(decrease) from the level prevailing on September 30, 2004, the ceiling
on net domestic assets would be increased (decreased) by an amount equivalent
to the change in the standard reserve requirement ratio multiplied by
the programmed deposit base used in the calculation of required reserves.
Before making any changes to the reserve requirement, the NBS will consult
with Fund staff. Required reserves of banks placed under BRA administration
or liquidation will remain part of reserve money for program purposes.
Similarly, the CBM will consult with Fund staff before making any changes
to the reserve requirement.

G. Ceiling on External Debt-Service Arrears

21. Definition. External debt-service arrears are defined as overdue
debt service arising in respect of obligations incurred directly or guaranteed
by the public sector, except on debt subject to rescheduling or restructuring.
The program requires that no new external arrears be accumulated at any
time under the arrangement on public sector or public sector-guaranteed
debts.

22. Reporting. The accounting of nonreschedulable external arrears
by creditor (if any), with detailed explanations, will be transmitted
on a monthly basis, within two weeks of the end of each month. This accounting
will include, separately, arrears owed at the union level, by the Serbian
and Montenegrin governments, and other public sector entities; arrears
owed by Yugoslav Airlines; and arrears owed to Paris Club creditors, London
Club creditors, and other creditors. Data on other arrears, which are
reschedulable, will be provided separately.

H. Ceilings on External Debt

23. Definitions. The ceiling on contracting or guaranteeing of
new nonconcessional external debt by the public sector with original maturity
of more than one year applies not only to debt as defined in point No.
9 of the Guidelines on Performance Criteria with Respect to Foreign Debt
adopted on August 24, 2000 (Decision No. 12274-(00/85), see attachment
to this Annex) but also to commitments contracted or guaranteed for which
value has not been received. Excluded from this performance criterion
are loans from, or other indebtedness to, the EBRD, the EIB and EU, the
IBRD, the IMF, and the IFC. However, in 2004 cumulative from December
31, 2003, contracting or guaranteeing by the public sector of new nonconcessional
external debt from the EBRD, the EIB and EU, the IBRD, and the IFC will
not exceed US$500 million by end-June 2004, US$500 million by end-September
2004, and US$500 million by end-December 2004 (Annex
A defines the separate ceilings applicable for Serbia and for Montenegro).
In 2005 cumulative from December 31, 2004, contracting or guaranteeing
by the public sector of new nonconcessional external debt from the EBRD,
the EIB and EU, the IBRD, and the IFC will not exceed US$100 million by
end-March 2005, US$200 million by end-June 2005, US$300 million by end-September
2005, and US$400 million by end-December 2005 (Annex
A defines the separate ceilings applicable for Serbia and for Montenegro).Contracting
or guaranteeing of new debt will be converted into US$ for program purposes
at the cross exchange rates implied by the official NBS exchange rates
in effect on the day of the transaction. Concessionality will be based
on a currency-specific discount rate based on the ten-year average of
the OECD's commercial interest reference rate (CIRR) for loans or leases
with maturities greater than 15 years and on the six-month average CIRR
for loans and leases maturing in less than 15 years. Under this definition
of concessionality, only debt with a grant element equivalent to 35 percent
or more will be excluded from the debt limit. Second, with regard to the
ceiling on new external debt with original maturity of up to and including
one year owed by the consolidated general government or guaranteed by
the public sector, the term "debt" has the meaning set forth
in point No. 9 of the Guidelines on Performance Criteria with Respect
to Foreign Debt adopted on August 24, 2000 (Decision No. 12274-(00/85).
Excluded from this performance criterion are normal short-term import
credits.

24. Reporting. A debt-by-debt accounting of all new concessional
and nonconcessional debt contracted or guaranteed by the public sector,
including the original debt documentation, details on debt service obligations,
as well as all relevant supporting materials, will be transmitted on a
quarterly basis, separately by Serbia and Montenegro, within four weeks
of the end of each quarter.

I. Ceiling on the Wage Bill of Serbian Public Enterprises

25. Definition. For December 2004, the performance criterion is set on
the total annual wage bill of seven large public enterprises: JP Elektroprivreda
Srbije, JP Naftna Industrija Srbije, JP Zeleznicko Transportno Preduzece
Srbije, JP PTT Srbije, JP Srbija Sume, JP JAT Airways, and JP Telekom
Srbija. For 2005, the performance criterion is set on a quarterly basis
on the cumulative monthly wage bill of eight large public enterprises
(the same seven enterprises as in 2004 plus JP Aerodrom Beograd). Wages
are accounted on an accrual basis, excluding taxes and social security
contributions, and include overtime payments and bonuses. Ceilings for
end-December 2004 and for end-March 2005 are performance criteria set
in the Fourth Review.

26. Adjustors. In the case of spin-offs of activities from these companies
(defined as the spinning off of a unit or its transfer to another entity
or temporary/permanent transfers of employees) after end-September 2004,
the wage bill target will be adjusted downwards for the wage bills of
spun-off units. In the case of EPS, the successor companies (according
to MEFP paragraph 35, bullet two) will all be included in the wage ceiling.

27. Reporting. The wage bills of the eight monitored state-owned companies
will be reported monthly to the European Department of the Fund and the
Office of the IMF Resident Representative by the Ministry of Finance (Public
Utility Restructuring Unit) with a lag of less than four weeks. Monthly
data for JP Aerodrom Beograd will also be provided for the period January
through December 2004.

Serbia (In CSD millions)

2004

2005

Dec

Mar

Jun

Sep

Dec

Wage Bill ceiling

30,230

8,030

15,941

24,180

32,700

J. Adjustor for Lower-Than-Targeted Severance Payments

28. Within the overall expenditure envelope of the 2005 budgets for the
central government in Serbia, the Union level government, and the Serbian
Transition Fund a total amount of CSD 8.2 billion is envisaged for severance
payments, out of which (a) CSD 5.0 billion related to employment reduction
in the Serbian central government; (b) CSD 2.0 billion related to employment
reduction on the Union level; and (c) CSD 1.2 billion included in the
funds for the Transition Fund related to employment reduction in the eight
monitored state-owned enterprises listed in paragraph 24 of the TMU. While
the expenditures under (a) and (b) will be financed through general budgetary
revenue, expenditures under (c) will financed through privatization receipts.
To ensure that these budgetary resources can be spent only for the intended
severance payments, the ceiling on net credit of the banking system to
the consolidated general government (performance criterion) and on net
credit of the banking system to the Serbian consolidated general government
(indicative target) will be adjusted downwards for the total shortfall
of the respective severance expenditures in categories (a), (b), and (c).

Serbia: Projected Cumulative Path
of Redundancy Payments in 200
in billions of dinars

March

June

September

December

Category a

0.0

0.0

5.0

5.0

Category b

2.0

2.0

2.0

2.0

Category b

1.0

1.2

1.2

1.2

Total

3.0

3.2

8.2

8.2

III. Other Reporting Requirements for Program Monitoring

A. Macroeconomic Monitoring Committee

29. A macroeconomic monitoring committee, composed of senior officials
from the Union Government, Serbian and Montenegrin Ministries of Finance,
the NBS, CBM, and other relevant agencies, shall be responsible for monitoring
the performance of the program, informing the Fund regularly about the
progress of the program, and transmitting the supporting materials necessary
for the evaluation of performance criteria and benchmarks.

B. Developments on Structural Performance Criteria
and Benchmarks

30. The authorities will notify the European Department of the Fund of
developments on structural performance criteria and benchmarks
as soon as they occur. The authorities will provide the documentation,
according to the dates in Annex C, elaborating on
policy implementation. The authorities will also notify the European
Department of the Fund expeditiously of any economic developments or policy
measures (prior to taking such measures in the latter case) that could
have a significant impact on the implementation of this program.

C. Data Reporting

Production and prices

31. Any revision to relevant macroeconomic data will be transmitted within
three weeks of the date of the revision.

Public finance

32. Monthly data on public finance will include a consolidated budget
report of the state governments (including union level operations), transmitted
within four weeks of the end of each month comprising:

The revenue data by each major item, including that collected by the
state and local governments, as well as the social funds (also including
"own revenue" of direct budget users);

Details of current and capital expenditure at the union, state, and
local levels, as well as those of the social funds (also including "own
expenditure" of direct budget users); and

Details of budget financing, both from domestic, and external sources,
including total privatization receipts and Treasury bill issues and
repayments (in the format described in paragraph 27).

Montenegro will report quarterly arrears data starting from end-December
2003 for the consolidated general government in Montenegro, separating
out normal float, and providing end-quarter stocks of arrears and gross
repayments of outstanding arrears during each quarter.

Monetary sector data

33. The following data will be transmitted on a daily/weekly/biweekly
basis within one/five working days of the end of each day/week.

Daily movements in gross foreign reserves of the NBS at current and
program exchange rates and gold prices, indicating amounts sold/bought
at the auction, in foreign exchange offices and on the interbank market,
inflows of foreign grants, inflows of foreign loans, and repayments
of frozen foreign currency deposits.

Outstanding stocks of Treasury bills, Treasury bill repayments made
during the reporting period, and auction details (yields, amounts per
maturity and number of banks participating in the auction per maturity).

Interbank foreign exchange rates and volume of transactions, including
rates and volume of trading outside the fixing session.

Ten-day report on public sector borrowing and lending from commercial
banks and the NBS.

Ten-day report on required reserves and the reserve base.

34. The balance sheet of the NBS and the consolidated balance sheets
of Serbian commercial banks, as well as the balance sheet of the Central
Bank of Montenegro and the consolidated balance sheets of commercial banks
in Montenegro, will be transmitted on a monthly basis within three weeks
after the end of each month. The stocks of government and NBS securities
held by banks and by nonbanks, as available to the NBS, detailed information
on interbank money market transactions (terms, duration, and participating
institutions), and interest rate developments will be transmitted on a
monthly basis within two weeks after the end of each month. Credit to
government by the banking system is provided with detailed breakdowns
on the union, state, and local governments.

35. The following data will be transmitted on a monthly basis:

NBS foreign exchange reserves held in accounts abroad, foreign banknotes,
and foreign securities as well as interest income on foreign assets.

Data on foreign borrowing by commercial banks with a breakdown according
to maturities.

Individuals' foreign exchange savings in top ten banks.

Grants and loans disbursement as well as debt amortization and interest
payments.

External data

36. The data below will be transmitted as follows:

The interbank market exchange rate, as the simple average of the daily-weighted
average buying and selling rates, will be transmitted on a weekly basis
within five business days of the end of the week;

Balance of payments data on services, private transfers, and capital
account transactions will be transmitted on a quarterly basis within
four weeks of the end of each quarter;

Detailed monthly data on the volume and prices of exports and imports,
separating out imported petroleum products; and

External debt data and debt service schedules separately for Serbia
and for Montenegro, with breakdown by creditor.

The CBM will provide quarterly updates of the Montenegro balance
of payments, including projections for the current and subsequent year,
while the Montenegro Ministry of Finance will provide the external debt
and debt service information described above.

1Annex A,
attached to this memorandum, contains the quantitative performance criteria
and indicative targets, while Annexes B and C list
the structural performance criteria and benchmarks as well as prior actions.
Annex D (Technical Memorandum of Understanding, TMU)
defines the performance criteria and indicative targets and describes the
reporting arrangements.2In terms of Serbian GDP, the consolidated
Serbian fiscal deficit is projected to decline from 3.2 percent of GDP in
2003 to 1.9 percent of GDP in 2004 (from 2.7 percent to 1.3 percent excluding
FLFPs).3In terms of Serbian GDP, the overall deficit
will be cut by 1.3 percent of GDP in 2005 to 0.6 percent of GDP in 2005
(a surplus of 0.1 percent excluding FLFPs).4The number of monitored enterprises increases
to 8 from January 1, 2005 (see paragraph 24 of the TMU).